17/3/2012: Long-term impact of unemployment - US study, Irish implications

An interesting study by Steven Davis and Til Wachter titled "Recessions and the cost of job loss"published by Becker Friedman Institute for Research in Economics Working Paper No. 2011-009 aims to quantify some of the effects of jobs displacement in the recession on cumulative losses in earnings. The study uses microdata from Social Security records for US workers from 1974 to 2008. 


Some findings:

• In present value terms, men lose an average of 1.4 years of re-displacement earnings if displaced in mass layoff events that occur when the US unemployment rate is below 6 percent. 
• Men lose double that - 2.8 years - of pre-displacement earnings if they lose their job when the unemployment rate exceeds 8 percent. 
• To add to authors conclusions: if you think of it in terms of the life-time losses, this is equivalent to roughly 14% loss in life-time earnings. Now, if you put this into a retirement perspective - this amounts to roughly 1/3 of an average funded retirement stream of earnings.
• Some more granularity on the study results: "For men with 3 or more years of prior tenure who lose jobs in mass-layoff events at larger firms, job displacement reduces the present value of future earnings by 12 percent in an average year. The present value losses are high in all years, but they rise steeply with the unemployment rate in the year of displacement. Present value losses for displacements that occur in recessions are nearly twice as large as for displacements in [economic] expansions. The entire future path of earnings losses is much higher for displacements that occur in recessions. In short, the present value earnings losses associated with job displacement are very large, and they are highly sensitive to labor market conditions at the time of displacement."
• The study also finds "large cyclical movements in the incidence of job loss and job displacement and present evidence on how worker anxieties about job loss, wage cuts and job opportunities respond to contemporaneous economic conditions". 
• More specifically on the above point: "Drawing on data from the General Social Survey and Gallup polling, we examine the relationship of anxieties about job loss, wage cuts, ease of job finding and other labor market prospects to actual labor market conditions. The available evidence indicates that cyclical fluctuations in worker perceptions and anxieties track actual labor market conditions rather closely, and that they respond quickly to deteriorations in the economic outlook. Gallup data, in particular, show a tremendous increase in worker anxieties about labor market prospects after the peak of the financial crisis in 2008 and 2009. They also show a recent return to the same high levels of anxiety. These data suggest that fears about job loss and other negative labor market outcomes are themselves a significant and costly aspect of economic downturns for a broad segment of the population. These findings also imply that workers are well aware of and concerned about the costly nature of job loss, especially in recessions."

While re-parameterizing the US labour market experience as revealed in the study into that in Ireland is not possible, the above results very clearly point to the extremely significant implications of the current unemployment in Ireland on expected future life-time earnings of a large proportion of our population. In Ireland, we have not even began assessing the impact that current unemployment crisis will have on:

• future economic growth (via earnings-savings-investment and earnings-consumption links which imply that previous unemployment-related reduction in life-time earnings will have significant, potentially double-digit-sized adverse drag on savings, investment and consumption levels, let alone growth rates, into the future) 
• fiscal revenues in the future (via earnings-tax revenues links which imply reduced tax revenues levels from consumption, investment and income taxes into the future) 
• retirement funding and demand for public health and pensions (via earnings-savings-investment links which imply reduced funding for retirement and private health)
• education funding for children (via reduced earnings of parent impact on children education) and
• the links between current debt levels, property markets, future investment and economic activity.

Neither do the above results cover the Irish-specific case of household wealth destruction and debt overhang accompanying the stratospheric rise of unemployment.

07/11/2011: Sunday Times, Nov 06, 2011

This an unedited version of my article for Sunday Times, Nov 06, 2011 edition.

In a recent research paper titled “The real effects of debt” Bank for International Settlements researchers, S. Cecchetti, M. Mohanty and F. Zampolli provide analysis of the long-term effects of debt on future growth. The authors use a sample of 18 OECD countries, not including Ireland, for the period of 1980-2010 and conclude that “for government debt, the threshold [beyond which public debt becomes damaging to the economy] is in the range of 80 to 100% of GDP”. The implication is that “countries with high debt must act quickly and decisively to address their fiscal problems.” Furthermore, “when corporate debt goes beyond 90% of GDP, [the] results suggest that it becomes a drag on growth. And for household debt, … a threshold [is] around 85% of GDP.”

Thus, combined private non-financial and public debt in excess of ca 255% of GDP exerts a long-term drag on future growth even in the benign environment of the Age of Great Moderation, the period from the mid-1990s through 2007, when low inflation and cost of capital have spurred above-average global growth.

The period under consideration in the study, was also the period when Baby Boom generation was at its prime productive age, when rapid expansion of ICT drove productivity in manufacturing and services, and innovations in logistics revolutionized retailing (the so-called Wal-Mart effects).

And yet, despite all the positive push forces lifting the growth rates the negative pull force of building debt overhang was still visible. Euro area economies have posted average growth rates of 2.0% per annum in 1991-2007, well below less indebted group of smaller advanced economies that posted average annual growth of over 4.2%.

From the Irish perspective, these impacts of debt overhang on long-term growth present a clear warning. Ireland’s robust growth in the 1990s and through 2007 represent not a long-term norm, but a delayed catching up with the rest of the advanced economies. In other words, even disregarding the negative effects of the severe debt overhang we experience today, Ireland’s average growth rates in the foreseeable future will be close to the average growth for smaller open economies in the euro area. That rate, according to the IMF latest forecasts, is unlikely to be significantly above 2.0%.

But Ireland’s debt overhang, when it comes to debt that matters – i.e. debt analyzed by Cecchetti, Mohanty and Zampolli – is beyond severe. It is outright extreme. Across the 18 advanced economies, average real economic debts weighted by the economies’ size stood at 307% of GDP at the end of 2010 and are expected to rise to ca 310-312% of GDP or GNP. Ireland’s real economy debt to GDP ratio is likely to reach above 415% of GDP and, more importantly, 490% of GNP. (Chart below)

According to the Bank for International Settlements econometric model, the above overhang can be expected to reduce Irish GDP growth by ca 0.7 percentage points over the long run, implying that our long term potential growth rate rests somewhere closer to 1.3-1.4% per annum on average.

At these rates of growth, our Government debt repayments, even if the entire pool of Irish bonds were financed at the lowest currently available rates – the EFSF 3.3% – Ireland nation debt financing will be consuming the entire surplus generated by economic growth.

This issue frames the entire discourse about the ‘green shoots’ allegedly emerging on Ireland’s economy landscape.

In October, according to the NCB Purchasing Index Irish manufacturing sector moved back into growth territory. The headline index, however, came in at an anaemic 50.1 (index above 50 mark signaling growth). Crucially, jobs prospects continued to deteriorate with sub-index for employment standing at 47.1. New exports orders – the leading indicator of our exports-led ‘recovery’ still underwater at 49.8. Profit margins for Irish manufacturing firms continued to contract for the 32^nd consecutive month.

Even our much celebrated trade data is starting to flash warning signs. In August – the latest period for which trade statistics are available – seasonally-adjusted trade surplus was a hefty €3,699 million. This figure represents a year-on-year decrease of 1.3%. Given this trend, in annual terms, for eight months through August 2011, Irish trade surplus is running at 0.5% below 2010 result.

Per latest IMF projections, in 2012-2016, Irish current account surpluses are expected to average 1.38% of GDP per annum. Despite unprecedented collapse in imports, fuelling trade growth does require new debt financing and imports of inputs. Small open economies’ average forecast for the euro area is 1.94% over the same period. In other words, less indebted countries of the euro area are expected to generate greater current external surpluses than more indebted Ireland. Get the point? Debt overhang can hold back even exports-led recoveries.

The debt overhang is now also exposing the underlying weaknesses in the Exchequer fiscal adjustments. Lack of consumer demand, investment, and the resultant implosion of domestic economy are now driving the state finances deeper into the red despite massive capital spending cuts and sizeable tax increases over the last three years. The latest tax receipts show that in 10 months through October 2011, income tax receipts are behind the budgetary target by 1.2%, VAT -4.5%, corporation tax -4.2%. Adjusting for the hit-and-run pensions levy, year on year tax Exchequer deficit is down just €155 million. Fuelled by stubbornly high unemployment and lack of any real reforms in public finances, voted current exchequer expenditure is up from €33,662 million in 10 months to October 2010 to €34,450 million for the same period this year.

All indications so far are that the second half 2011 growth will once again post a nominal GNP contraction and quite possibly the same for nominal GDP.

Courtesy of overburdened households and companies, Irish economy is now stuck in a quick sand of a balance sheet recession, which risks becoming a full-blown decades-long stagnation. Even our greatest hope – improving competitiveness – is being threatened by debt. Again, referring to the latest data, despite the past gains, Ireland remains the least competitive 'old' euro area economy. Ireland has competitiveness gap of 34.7% compared to Germany and 14.7% compared to euro area as measured by differences between our harmonized competitiveness indicators. This gap will be virtually impossible to close, as the gains in competitiveness to-date have been driven primarily by jobs destruction and earnings declines. Cutting even deeper into earnings by raising taxes and/or reducing employment costs will either risk destabilizing even more our sick banking sector or will require cuts in taxes to compensate for disposable income losses.

To summarize, there is no hope of growing out of the debt crisis we face when the expected growth this economy can achieve in the next decade or so is roughly ten times smaller than the debt repayments we have to finance for the combined public and private non-financial debt. Once we rule out sovereign debt restructuring, the only solution to our crisis will require reducing the private sector debt overhang.

Box-out:

This week, European Financial Stabilization Fund postponed placement of €3 billion new bonds that were earmarked to provide new funding for Ireland under the Troika agreement. The funds are critical to our repayment of the €4.39 billion in Government bonds maturing November 11. While no one expects the Government to fall short on bonds redemption, the delay in raising EFSF funds is worrisome from the broader Euro area perspective. The hopes of leveraging the EFSF from its current €440 billion lending capacity to €1 trillion or more have hit a number of snags in recent days with all BRIC countries, the G20, the UK and Japan all suggesting that they will be unwilling to invest in EFSF leveraging on the basis of the terms implied by the current arrangements. The suspension of the latest issue, coming on foot of the original plans for 3.3% coupon pricing of the new and much smaller debt further extends concerns about the EFSF ability to leverage up. The EFSF leveraging is designed to provide cover for sovereign bonds of Italy and Spain, as well as for some limited capital supports to the euro area banking sector. If the EFSF cannot issue unlevered bonds at 3.3%, the implied commercial rates for levered EFSF issuance can be somewhere North of 5.25%. Costs and even the shallowest of the margins will push the effective lending rate to the member states to above 5.5%. Yet, at these rates, Italy’s sovereign financial imbalances cannot be sustained, regardless of whether the country deficit is 5% or 2%. Ditto for Portugal, and Greece, and Ireland. In other words, there’s not a snowball’s chance in hell the latest EU proposal for leveraging EFSF will work, given this week’s fiasco.

14/09/2011: More soft slop from Irish stuff-brokers

You gotta hand it to the Irish stuff-brokers community. They do routinely produce pearls of wisdom that we, the mere mortals can only aspire to. Here's one latest installment from one morning note issued today:

"If Ireland can meet its deficit cutting/growth targets over the next 2 years, then investor demand for Irish bonds should remain firm".

Let's start peeling this profoundly rhetorical onion:

1. The problem with Irish bonds is that there is NO demand for them. This is why we can't sell them and this is why we are reduced to borrowing from EFSF/EFSM/IMF/Bilateral Begging Bowl. So - the law of physics lesson for stuff brokers - that which doesn't exist cannot "remain firm".
2. If we can sustain our "deficit cutting / growth targets" over the next 2 years (i.e., given I see on my calendar "September 14, 2011") we will be in mid-September 2013 - at which point, per IMF/DofF/ESRI and other folks, usually not renown for their pessimistic assessments of our 'targets', Ireland will be at the peak of our substantial sovereign debt pile. If our stuff-brokers think that is a scenario consistent with "firm" investor demand for bonds, I wonder if the FR should suggest they attend some basic courses in finance.
3. What the hell does construction "deficit cutting / growth targets" mean? Usually, "/" implies "or". At the very least - "and / or", though that construction has own logical sign "v" as in "A ∨ B is true if A or B (or both) are true" of course, "A ⊕ B is true when either A or B, but not both, are true, which can also be written as A ⊻ B". So suppose our stuff-brokers think that delivering on our "deficit cutting" or "growth targets" (but not both) will assure "firm demand" for our bonds. We can, therefore, have NTMA going into the market telling the potential investors: "Give Ireland a chance. We have budgetary consolidation (economic growth), but no economic growth (deficits and debt sustainability)". Again, such a proposition suggests that more basic finance & economics courses are in order.

I am not being pedantic, folks. The problem is that this rhetorical exhortation can easily serve as an example of what passes for policy thinking in Ireland's more august quarters (DofF, Government, Dail, etc). It is an exact formula of what the Government / ESRI / IBEC etc have been putting forward as our policy to resolve the crisis. And yet... yet it makes absolutely no sense.

4/02/2011: Another glitch in our 'knowledge' economy?

Anyone reading this blog more than once or twice would know by now - I've got plenty of deficit cutting credentials. But sometimes, the absurdity of cuts and associated policies can get even to a hawk like myself. So here we go, again.

Here's an extract from the HEA to administrators and heads of schools in Irish Universities, dated, per my source, from January 19th last:

"As you are aware the Employment Control Framework for the higher education sector expired on the 31st December 2010. A revised framework for the sector, which will operate until 31 December 2014, is currently being drafted. Some further reductions in the number of posts that may be filled will be required under the new Framework. We will inform you as soon as possible of the revised reduced targets for your institution.

Pending finalisation of the revised Framework I wish to advise that all proposals for recruitment of staff, both contract and permanent and regardless of source of funding (core grant, research grant or non-exchequer), must be submitted in advance to the HEA."

Ok, so HEA are requiring explicit approval for all hires. sounds reasonable? Sure, if we are talking about the normal course of business. But imagine the following situation:

A researcher gains a very large EU research grant that requires hiring research assistants and post-doctoral researchers. The funds have nothing to do with the Irish Exchequer deficit. The job is specified and milestones are set in... err... kind of set in stone. But HEA approval requires time - as I've heard, up to 3-6 months. Now, imagine the researcher blowing through the milestones and losing a grant. Some savings to the Exchequer? Nope - actually - a loss. Exchequer loses income tax from the hires who never materialized, from the purchasing done for the purpose of research and so on.

And there's an added danger - if such uncertainty is present in the market for new researchers and promotion, the brighter academics might discount Ireland as a good research location. After all, academic market is truly global, folks.

Is that a serious problem? Yes, a number of researchers I have heard of are currently in this predicament with one being just a few days from giving an offer to a junior research staff.

Now imagine another scenario - also, per my sources close to playing out. A major corporation decides to provide a grant to an Irish University for research. The grant stipulates hiring certain number of researchers and other staff. Oops... the letter goes out to the corporate headquarters, saying that HEA approval is needed. What's the likelihood that the grant is going to travel to the UK? Or another jurisdiction, where fiscal cuts might be in place, but policymakers have some finesse to understand that when the money comes from outside the state coffers, hiring decisions should be made by those managing these funds...

What beats me is why can't the Exchequer simply allocate funds to universities and let the academic and administrative staff manage these funds in line with each university/school/department own objectives? Why is there such a need to micromanage fiscal adjustments.

Oh, and while we are at it, here's another question. If we stop renewing and issuing new contracts for post-docs, how fast will the reality of unemployed phds arrive to our shores? And what will happen to our knowledge economy's grand plan for doubling phds output?..

Economics 31/10/10: Mortgages, relief and stimulus

David McWilliams' idea of deferring mortgage repayments for 2 years is continuing to generate some discussions in the 'new' media. Here are my thoughts on the topic.

David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.

As expected incomes fall due to:

• continued recession in the economy (courtesy of the insolvency crisis we face across the entire economy);
• elevated risk of unemployment (ditto);
• rising tax burden on households (courtesy of the Government's perverse logic which puts the needs of financial services and Exchequer ahead of those of the real economy - households and firms);
  
• heightened risk of further tax increases in the future (ditto);
  
• behavioral implications of the severe and deepening negative equity (being further reinforced by the FR and Government denial of the problem and asymmetric treatment of development debts and household debt); and
• continued increases in the cost of mortgages finance and credit (courtesy of the Government approach to dealing with the banking crisis)
  

Irish households are indeed under a severe financial stress. This stress is amplified by the adverse selection of younger (and thus more heavily leveraged) households into the higher risk of unemployment. These very households are also more important contributors to future private investment side of the economy, as older households are dis-saving to consume.

Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.

The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.

Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:

1. Temporary suspension of mortgages repayments will not draw down the overall debt burden, as banks will reload increases in mortgage finance costs into the future to offset for losses incurred during the holiday even if there is no roll up of interest during the holiday. In other words - suspending mortgage repayment for 2 years will likely lead to banks pushing even higher cost of mortgages interest into years 3 and on for all households concerned;
2. Any rational household will anticipate (1) above to take place and will ramp up precautionary savings to compensate for expected cost increases in their mortgages, withdrawing even more cash from today's consumption. A mortgage holiday in these conditions will lead to zombie banks turning into zombie households;
3. Any rational household will, also in anticipation of (1) withhold any purchases of property until the full realisation of true future mortgage finance costs takes place post holiday;
   
4. If any suspension of mortgages finance involves rolling up of the interest for 2 years, the burden of future mortgage liabilities will increase dramatically, which, once again will be anticipated by the rational households. As a result, households will take 2 years worth of 'free' rent and then default at the point of interest roll up kicking in. We can expect a wall of mortgages defaults in 2013;
   
5. In order for the repayment holiday to have any real effect, the long term growth rate in personal disposable income will have to exceed: increase in the cost of mortgage finance post-holiday + inflation - tax increases expected. This, using current growth estimates etc suggests that in order for a 2 year holiday on repayment of mortgages to have any positive effect, our aggregate expected growth rate in personal income should be in excess of 50% in years 2013-2018. This is clearly not anywhere near being realistic.
   

Once again, the problem we face is the size of leverage taken on by the Irish households. Whether reckless lending or borrowing or both caused this problem is irrelevant. Households become long-term insolvent when their total debt liability rises above 4-5 times their earnings even in the moderate growth in income environment.

We have - on aggregate - households facing:

• current long and short term debt burden of ca 145% of GNP, and
  
• expected (2014) sovereign debt burden of ~140% of GDP or ca 165% of GNP (under rather optimistic assumptions on GDP/GNP gap) - at least 80% of this will have to be repaid out of the pockets of our households.
  

The problem is that these headline figures conceal imbalances in distribution of debt.

While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.

This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.

A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.

Economics 24/9/10: Still deep in denial?

Updated

In the real of bizarre, we have two fresh statements from Irish officials.

First, NTMA issued a statement claiming that Irish authorities - aka Irish taxpayers - will make up any shortfall on the banks capital side. One wonders if the NTMA has acquired new powers from the State - this time around, to determine our budgetary policy. You see, per European authorities, capital support for the banks is a matter of national deficits. National deficits are a matter of fiscal policy. Fiscal policy is firmly a matter for the Exchequer (i.e the Government). NTMA is neither the Exchequer, nor the Government. What business does it have in making promisory statements to the markets concerning the matters of fiscal policy?

Second, per Reuters report: "An Irish official told The Daily Telegraph that Dublin will "explore the appropriate burden-sharing arrangements" over coming weeks as it fleshes out its plan to break up the nationalised bank. Anglo Irish may ultimately cost Irish taxpayers as much as €25bn". So let's quickly summarize the statement:

1. After the economy posted a double dip (GDP side), having lost some €13,000 per every working person in income since the beginning of this Great Recession,
2. After all independent analysis has pointed, for some 21 months now to the need to cut loose the subordinated (and senior) debt holders in Anglo, plus subordinated debt holders in other state-supported banks,
3. After the above calls by independents was echoed in recent weeks in the international analysts opinions (e.g. RBS),
   
4. After independent analysts have correctly estimated Ireland's exposure to Anglo to be in the region of €33-39 billion, the estimate once again echoed in international analysts estimates (S&P),
5. After international bond markets have shown total disapproval for the Government handling of the recession, bidding both bond yields and CDS spreads to historic highs
   

our officials remain in a deep denial about both the extent of the problems and the required course of action.

Economics 17/9/10: Free markets are good for human capital

World Bank Policy Research Working Paper 5405, titled “Economic Freedom, Human Rights, and the Returns to Human Capital: An Evaluation of the Schultz Hypothesis” by Elizabeth M. King, Claudio E. Montenegro and Peter F. Orazem published in August 2010 is a very insightful read into the role of proper market institutions and rights in economic development. Paper link here.

T.W. Schultz postulated, back in 1975, an important hypothesis for why returns to schooling might vary across different markets. According to Schultz, human capital is most valuable when individual workers face unexpected price, productivity or technology shocks that require managerial decisions to reallocate time and resources.

In other words, in Schultz’s view, human capital acts as a hedge against such uncertainty. If skilled individuals are not exposed to shocks that require resource allocation decisions or if they are denied the freedom to make those decisions, then they will not be able to capture the economic returns from their skills.

It stands as a logic corollary that if a country imposes economic or political institutions that cushion the shocks or hinder individual economic choice, then we should observe lower returns to skill in countries that limit exposure and/or individual responses to uncertainty.

In the case, relevant to Ireland, this logic extends not only to traditional factors, such as:

• Degree of labour force unionization
• Extent of social welfare safety net
• Existence of the minimum wage laws
• Restrictions on mobility into public sector jobs and protected professions jobs
• Structures of pay and promotion divorced from productivity considerations
• Visa restrictions

and other buffers, but also more novel factors such as

• Negative equity
• Housing markets access restrictions (e.g. birth-right to development of homes in some areas)
• Cultural restrictions (e.g. Gaeltacht)
  
• Lack of credit supply, etc

Per World Bank study cited above:

“A cursory inspection of the data yields support for the hypothesis. … [dividing] data from 86 developing countries into three groups based on their relative ranking in the Heritage Foundation’s Economic Freedom Index, with 25% each placed in the least and most free economies and the rest being placed in the middle. … Private returns to schooling for the freest economies average 9.7% per year of schooling, 3 percentage points higher than the average returns in the most restrictive economies. Returns for the middle group fall between the two extreme groups. [The authors] repeat the exercise … for private returns to years of potential experience. Again, average returns are highest in countries rated as the most economically free (5%) versus the middle (4.7%) and least free (4.2%) countries. These results are broadly consistent with the proposition that freer economic institutions raise individual returns to human capital.”

Furthermore:

“T. P. Schultz (1998) found that about 70% of the income inequality in the world is due to country-specific fixed effects that would include the impacts of country-specific political and economic institutions on earnings. Acemoglu and Robinson (2005) argued that these institutions were formed in response to exogenous influences existing at the time of a country’s founding, and that these institutions tend to persist across generations. [World Banks study] use measures of economic and political institutions to determine if they can alter returns to human capital across countries sufficiently to explain some of the persistent cross-country income inequality reported by T. P. Schultz. [The study found] that, consistent with the T.W. Schultz hypothesis, human capital is significantly more valuable in countries with greater economic freedom. Furthermore, the positive effect is observed at all wage quantiles. Economic freedom benefits the most skilled who get higher returns to schooling; but it also benefits the least skilled who get higher returns from experience.”

Now, this has three basic implications for Ireland.

Firstly, the study results show that higher human capital returns (in other words greater incentives to invest in human capital) are associated with less restrictive labour market policies, greater extent of basic human rights protection, more pluralist system of social organization and lesser emphasis on equalization of outcomes in economic environment. In other words, market wins, crony capitalism (Irish model) and socialism (Swedish model) lose.

Secondly, the study also implies that if Ireland were to be focused on developing a viable knowledge economy (aka human capital-intensive economy), the country needs more market, more freedom, less protectionism and lower restrictions in the labour market.

Thirdly, the study suggests that environments with lower tax burden on labour and lower Government/State interference in private activities are more likely to produce better human capital base.

Instead of farcical Mr Top Hat Kapitalist, it looks like free markets and societies benefit Ms Advance Degree Holder.

Economics 16/9/10: Why a rescue package for Ireland might not be a bad idea

This is an edited version of my article in today's edition of the Irish Examiner.

Two weeks into September and the crisis in our sovereign bond markets continues unabated. Ireland Government bonds are trading at above 6% mark and given the perilous state of the Irish banks, plus the path of the future public deficits, as projected by the IMF, Ireland Inc is now facing a distinct possibility of our interest bill on public debt alone reaching in excess of 6% of GDP by 2015. [Note: by now, the magic number is 6.12% as of opening of the markets today].

Sounds like a small number? Here are a couple of perspectives. At the current cost of deficit financing, our Exchequer interest bill in 2009 was 1.7% of GDP or €2.8 billion. Within 5 years the interest bill can be expected to reach over €12 billion, based on the Government own projections for growth. By this estimate, some 30% of our expected 2015 tax receipts will go to pay just the financing costs of the current policies.

It is precisely this arithmetic that prompted the Financial Times this Monday to question not only the solvency of the Irish banking sector, but the solvency of the Irish economy. The very same inescapable logic of numbers prompted me to conjecture in the early days of 2009 that our fiscal and banks consolidation policies will lead to the need for an external rescue package for Ireland.

This external rescue package is now available, fully funded and cheaper (financially-speaking) to access than the direct bond markets. It is called the European Financial Stability Fund (EFSF). More than money alone, it offers this country a chance to finally embark on real reforms needed to restore our economy to some sort of a functional order.

The EFSF was set up to provide medium term financing at a discounted rate of ca 5% per annum for countries that find themselves in a difficulty of borrowing from the international markets. With effective yields on our bonds at 6.05% and rising – we qualify.

The EFSF requires that member states availing of European cash address the structural (in other terms – long term) deficit problems that got them into trouble in the first place. In Ireland’s case this is both salient and welcomed.

It is salient because, despite what we are being told by our policymakers, our problems are structural.

Banks demands for capital from the Exchequer – a big boost to Irish deficit last year and this – are neither temporary, nor dominant causes of our deficits. In the medium term, we face continued demands for cash from the banks. By my estimates, total losses by the Irish banks are likely to add up to €52-55 billion (ex-Nama) over the next three-four years. These can be broken down to €36-39 billion that will be needed in the end for the zombie Anglo, €6bn for equally dead INBS, at least €8 billion for AIB and up to €2 billion for the ‘healthiest’ of all – Bank of Ireland. These demands will come in over the next 24 months and face an upside risk should ECB begin aggressively ramp up interest rates in 2011-2012.

No economy can withstand a contraction in its GDP on this scale. Least of all, the one still running 5-7% of GDP structural deficits over the next 4 years. In 2009, banks demands for Exchequer funds managed to lift our deficit from 11.9% to 14.6%. This year, absent banks bailouts, our deficit will still reach around 11.3%. Only 3.3% of that due to the recessionary or temporary effects. In 2011, IMF estimates our structural deficit alone to be 7% and 5.9% in 2014.

Which brings us to the point that the use of the EFSF funds should also be a welcomed opportunity for Ireland.

A drawdown on EFSF funding will automatically trigger a rigorous review of our fiscal plans through 2015 by the European and, more importantly, IMF analysts. This is long overdue, as our own authorities have time and again proven that they are unable to face the reality of our runaway train of fiscal spending.

Since 2008 in virtually every pre-Budget debate, Minister Lenihan has been promising not to levy new taxes that will threaten jobs and incomes of the ordinary people of Ireland. In every one of his budgets he did exactly the opposite. Under the EFSF, the IMF will do what this Government is unwilling to do – force us to reform our tax system to broaden the tax base, increase the share of taxes contributions by the corporate sector and start shifting the proportional burden of taxation away from ordinary families.

Minister Lenihan has repeatedly promised reforms of spending. In every budget these reforms fell short of what was needed, while the capital investment was made to bear full force of the cuts. Drawing cash from the EFSF will make Mr Lenihan scrap the sweetheart Croke Park deal and start reforming current spending. Politically unacceptable, but realistically unavoidable, deep cuts to social welfare, public sector employment and wages, quangoes, and wasteful subsidies will become a feasible reality.

Starting with December 2009, the Irish Government faced numerous calls from within and outside this state (headed by the EU Commission and the IMF) to provide clarity on its plans to achieve the Stability and Growth Pact criteria of 3% deficit to GDP ratio by 2014-2015. The Government has failed to do this. Drawing funds from the EFSF will help us bring clarity as to the size and scope of fiscal adjustment we will have to take over the next 5 years.

Lastly, the EFSF conditions will include a robust change in the way we are dealing with the banks. Gone will be the unworkable Government strategy of shoving bad loans under the rug via Nama and drip-recapitalizations. These, most likely, will be replaced by haircuts on bond holders and equity purchases by the State.

Contrary to what the Government ‘analysts’ say, drawing down EFSF funds will not shut Ireland from the bond markets. Instead, swift and robust restoration of fiscal responsibility and more a more orderly exit of the exchequer from banks liabilities are likely to provide for a significant improvement in the overall markets perception of Ireland. After all, bond investors need assurances that we will not default on our debt obligations in the future. Only a strong prospect for growth and recovery can provide such an assurance. Ministerial press releases and Nama statements are no longer enough.

Economics 13/9/10: FT's belated recognition of Irish realities

In today's FT (here), Wolfgang Munchau clearly states that (emphasis is mine): "...Irish banking sector is insolvent, and there are questions about the capacity of the Irish state to absorb those losses. ...two years have passed [since the crisis acknowledgement by the state] and nothing has been resolved.

…As we saw last week, this strategy [of shoving bad loans under the rug via Nama and quasi-recapitalizations] came badly unstuck in Ireland. The Irish government massively underestimated the scale of the problem in its banking sector. On my own back-of-the-envelope calculations, the cost of a financial sector bail-out may exceed 30 per cent of Irish gross domestic product, if you make realistic assumptions about bad debt write-offs and apply a conservative trajectory for future economic growth.

[Note: this blog has previously (here), on a number of occasions estimated the overall impact of the net losses realized by the banks to Irish taxpayers will be in the region of €62-75 billion, inclusive of Nama. Based on the Department of Finance own figures, this can be expected to amount to 38.5-46.6% of Ireland’s 2010 GDP or 48-58.1% of our GNP. Either range of numbers is significantly in excess of Munchau’s back-of-the-envelope estimate.

However, even at 30% of annual GDP, the expected hit on this economy from the banking sector debacle is simply insurmountable.

No economy on earth can be expected to withstand a 30% contraction in its GDP over two-three years, while still running a 7-8% of GDP structural deficit in every one of these years. The insolvency of Irish banks recognized by Munchau, therefore, automatically implies the insolvency of our economy, unless the banks are isolated from the rest of our economy by a removal of the blanket guarantee on the bondholders, while retaining a guarantee on depositors.]

Munchau goes on to say that: “We know from economic history that countries enter into longish phases of stagnation after a financial crisis.

[My estimates based on the IMF and OECD models of fiscal and financial crisis imply that Ireland can expect at least another 33 quarters of continued crisis pressures in Exchequer finances, house prices and asset markets, as well as a permanent decline in the potential rate of economic growth to below 1.5%]

Ireland suffered an extreme crisis. In the light of what we know, the safe assumption to make for Ireland – and Greece – is that there will not be much nominal growth in the next five years. If you make that assumption, you realise Greece will almost certainly not be in a position to repay its debts. While Ireland’s situation is marginally better, there are justified doubts about the country’s long-term solvency.”

[The above are not some idle words. They are, as I mentioned early, fully in line with the existent econometric models of crises based on historical experiences in the advanced economies in the past.]

Per Munchau: “….In Ireland, the cure would consist of nationalisation and wiping out the bondholders of Irish banks through bond-to-equity conversions.”

[Needless to say, since April 2008 I am on the record – in the press, media, on this blog, in public meetings and private briefings to the policymakers – these are exactly the first steps that need to be taken in order to begin – note, just to begin – the process of restoring order to our banking system. Irony has it – on a number of occasions, I have written to the Financial Times precisely about these issues, raised by Mr Munchau, with, needless to say, not a peep back from the broadsheet offices].

Economics 27/8/10: Manifesto I (?)

I will continue posting on this and will aggregate all ideas in my Long Term blog, with a banner link on my main page as well. All suggestions welcomed & will be published, some will make it to the list as well (as always - with proper attribution). So engage with me on this one!


Given the current market and economic conditions and the dire lack of credible economic policies (from any political party) aimed at moving Irish economy out of the combination of:

• deeply rooted crisis in public finances;
• structural collapse of the banking sector;
• stratospherically high and increasingly long-term unemployment levels;
• lack of significant gains in competitiveness (not limited to the area of wages competitiveness, but including basic utilities costs, and costs of living and doing business relating to state-controlled sectors);
• malfunctioning markets for provision of domestic services - dominated and restricted by the excessive market power of the incumbent state-owned and state-regulated oligopolies;
• a clear predominance of policy measures that are designed to saddle ordinary families and individuals (consumers and taxpayers) with the full cost of stabilizing vested interests and elites (manifesting themselves in rising tax burden, falling provision of public services, lack of reforms in banking and public sectors); and
• continued devastation of private entrepreneurship and businesses, contracting investment and lack of confidence in the future of the economy and broader social progress

it is now time to ask:
Is Ireland's electorate ready for an alternative political and popular movement that would put the interests of consumers and taxpayers at the top of governance and policy agenda?

Irish democracy cannot be surrendered to the vested interests, no matter how broadly-based, and elites (no matter how meritocratic or mobile they might be).

The current crisis has clearly shown that the corporatist state - where a group of vested interests colludes with the Government and state structures to set economic and social parameters for development priorities - is morally, politically and economically bankrupt.

The only two ways forward from this status quo are

• a generations-long and exceptionally deep crisis of stagnation and declining standards of living, or
  
• a path of structural reforms aimed at realigning the current political system to serve the interests of consumers and taxpayers - aka - the ordinary citizens and residents of this land.
  

Such a reform can only be achieved by creation of a radically different alternative to the existent structures. A new popular movement can champion the rights of consumers and taxpayers to counterbalance existent system that promotes the interests of the vested pressure groups and elites.

It is therefore, clear to me that at this point in time Ireland is on the cusp of either opting for change or electing to undertake decade (if not decades) long descent into the nightmare of economic stagnation.

In my view, the agenda of such a movement should include the following reforms:

1) Banking reforms:

• Banks should be recapitalized following Swedish model (imposing haircuts/equity swaps on bond holders; accepting correct amounts of writedowns; equity taking by the State in the name of taxpayers; equity to be held in a Trust for individual taxpayers until disbursal; at disbursal - equity sales proceeds to be rebated, net of cost to the taxpayers)
  
• Nama to be reversed
• Anglo Irish Bank and INBS to be shut down and their liabilities and assets to be wound up within 5 years
  
• All banks boards and senior management teams replaced within 3 months
• All banks middle management teams reassessed and rebuilt within 12 months
  
• FDIC insurance scheme to be set up for the future needs of the sector
  
• No future bailouts constitutional amendment to be put to a referendum to prevent a possibility of any future calls on taxpayers wealth from any private sector firm
  

2) Fiscal reforms:

• Flat tax to be enacted on all incomes (preliminary estimates suggest 15-17% tax rate) with no discretionary deductions, but a generous upfront deduction of 1/2 of the median wage to be made available to all earners, plus 1/5 median wage deduction per child.
  
• Provision of strong (current level -10%), but life-time capped welfare provisions. Life-time cap will allow any able bodied adult in the country to have access to a cumulative maximum of 7 years of welfare provisions over their life time. Provision of welfare supports to those unable to work due to health or family circumstances (e.g caring for the disabled relative etc) to continue without life-time limits.
  
• Strong support for the disabled and the elderly must continue
• Wages for politicians and all senior servants earnings are to be tied to the National Disposable Income (NDI) on per capita basis (pcNDI): Taoiseach=3.5 times pcNDI; Ministers=3 times pcNDI; senior civil servants=max 2.7 times pcNDI; TDs/Senators=2.5 times pcNDI and so on. If the country earns more in disposable income, then those running it should get a reward, otherwise, they will automatically bear the same burden as the rest of economy. No bonuses to be allowed and all pensions to be converted to Defined Contribution plans.
  
• Benchmark Government spending to 35% of GDP, with emergency spending not to exceed 37% of GDP in any given year, and a balanced budget over every 3 year period. This allows for small emergency spending boosts in recessions, but prevents spending sprees in elections etc
  
• All quangoes, except those with immediate independent oversight authority (e.g FR and Competition Authority) are to be abolished and their functions transferred to respective departments. Responsibility for governance and management must rest with the executive branch of the state - i.e. Government.
• There should be no taxation without representation - self-employed individuals who are fully tax compliant should have access to same unemployment benefits as anyone else.
• Tax system should be fully reformed to simplify existent taxation and ensure full compliance. This will include, in addition to the flat income tax - abolition of all indirect charges and taxes, other than direct user fees which will be fully ring-fenced to provide revenue necessary to maintain specific service (e.g. bin charges, water rates etc). VRT will be abolished. Any excise taxes will be set at a level required solely to support provision of services directly associated with the underlying consumption charged. For example, petrol levy will apply only to the amount required to support environmental programme related to CO2 abatement and improvement of the environment. It will not be allocated into the general budget. There will be a fully transparent tax on land values (LVT), but not a property tax. The revenue from LVT will be split 50:50 between central & local authorities and local authorities will be allowed a discretion to vary their rate of LVT within reasonable parameters. For example, if LVT is levied at 1% pa, then local authority can be allowed to charge between 0.25% and 0.5% as it deems suitable, while the central government will collect 0.5%. CGT and CAT will be abolished for all investments held for 5 years or longer to encourage longer term savings and investment.
  

3) Governance reforms:

• Core change to the Government model will be transparency and accountability based on automatic systems of disclosure and control that are not subject to tampering by individual ministers/politicians or civil servants
  
• Transparency: all state data/decisions/discussions not subject to secrecy of the state considerations will be published on the web and made accessible free of charge to all residents of the state. Commercially sensitive data will be published with exclusion of sensitive information and identifiers, until the time when it can be published in full. All data requested under FOI will be released free of charge to the requestee and will be automatically published also on the public web portal to remove any need for future FOI requests
• Accountability: performance and productivity metrics will be designed for all branches of public sector and wages and earnings in the public sector will be tied into these.
  
• Any attempts by public employees or office holders to undermine the principles of transparency and accountability in dealing with the public will be punished on the basis of publicly available procedures. All disciplinary actions against aforementioned employees or office holders will be made publicly available.
• Local authorities will be reformed, reducing the overall number of local authorities to 7, covering: West & North West, South, Greater Cork, Greater Dublin, Greater Limerick, Greater Galway and Border & Midlands.
• Seanad will be reformed (subject to referendum) to give it real powers of the upper chamber comparable to the US Senate. It will be elected directly by the people of Ireland, with equal representation of 5 senators from each of the 7 geographic region outlined above.
• Dail will be reformed - there will be no expenses, no additional pay for work in special committees (every TD will be required, subject to seniority to carry such work as a part of their duties). The number of TDs will be reduced to roughly 2/3rd of the current. TDs will be entitled to a defined contribution pension top up to their existent private pensions with the state matching 1:1 every euro they put into their pension.
• Members of the cabinet will have no drivers, state cars and there will be no Government jet. Members of the cabinet will qualify for a car allowance equivalent to €10,000 per annum. All members of the Oireachtas and Government traveling on official business will be reimbursed only to the full cost of the ticket for economy flight on any flight under 5 hours of length and business class for flights of longer duration. No employee of the State will be entitled to any travel reimbursement in excess of an economy class ticket.
  
• No member of the Oireachtas or employee of the state will be exempt from any of the standard tax codes or laws of this land. There can be no privilege for the servants of the public that the public itself cannot claim.
• All state purchasing will be carried on-line, made public and transparent.
  
• State will purchase services, such as health care, care for the elderly, disabled etc for those who cannot afford them, but the State will not own service providers. Instead, public companies will be mutualized or privatized and forced to compete directly for the custom of the people. Transition to such an arrangement will require significant reforms, but also support for current employees in training them in running a private/mutual/non-profit etc enterprises. This support will be provided.
• Higher education will be fees-based, with fees set by universities and overseen by the Department for Education. The State will set up (with participation of charities and other private agencies) a number of funds that will administer financial aid to students based on need (with an objective of creating an equal opportunity for all qualified students to undertake studies) as well as merit (with an objective of rewarding real achievement).

In the name of sanity, I should pause for now. I will continue posting on this and will aggregate all ideas in my Long Term blog, with a banner link on my main page as well.

All suggestions welcomed & will be published, some will make it to the list as well (as always - with proper attribution). So engage with me on this one!